Explaining Herd Behaviour in Investing

It seems sort of obvious that investors, a generally bovine group when not in asinine mood, will tend to congregate in herds and then charge about randomly, often over the edge of the nearest cliff. If this is true, however, it poses a set of puzzles that it's not clear that any of the current approaches to understanding mass market behaviour can properly explain. Certainly this behaviour isn't efficient in the sense of obtaining the right price for a security, because deciding what to do based on the person running about in ever-decreasing circles next to you doesn't come close to propagating useful information. However, if investors are irrational in herds then this implies that somehow their behaviour is synchronised and it's certainly not clear that the simple set of isolated psychological biases that analysts currently work with is anywhere near sufficient to explain this.Flocking and Herding

A simple model of flocking in computer models has been shown to be sufficient to generate surprisingly realistic herding behaviour – the sort of thing we looked at in Boids, Bacteria and Market Behaviour. Being able to show that this type of model can produce something that looks like the synchronised behaviour we see in the real-world is a long way from explaining how it works, however, because humans demonstrate intentionality – that is, we don't normally work on some pre-programmed autopilot but have internal motivations that cause us to do things based on personal preferences. Or do we? One of the other noticeable attributes of humanity is its strong tendency for mimicry. From a very young age human children copy adults and the urge to imitate is found in many higher animals. Indeed it's been suggested that the large human brain evolved in response to selective pressures to copy others. This idea would be more credible if there weren't dozens of alternative evolutionary theories for the size of our crania – this one-size-fits-all theorising is one of the reasons why many people are sceptical of adaptationist claims: natural selection can be adduced to explain everything, so in the end may explain nothing.Information Cascades

This aside, it certainly seems that mimicry lies behind a lot of observable animal behaviour, from mate selection through to dietary choices. Especially in situations of uncertainty it makes perfect sense to copy what everyone else is doing. You just hope that when the fire alarm goes off the confident person everyone else is following knows where they're going. What psychology suggests is that sometimes these mimicry effects can set off information cascades – a kind of chain reaction where everyone copies everyone else thinking that everyone else knows what they're doing. At this point we're no longer doing our own rational analysis but are simply copy the nearest available role models, whether these are neighbours, internet buddies or just the bloke in the bar last night. Information cascades have a number of interesting qualities: they can emerge quickly based on the behaviour of a few dominant individuals but they're very fragile, because the receipt of new and conclusive information can cause people to suddenly change their minds. They're also associated with sudden stampedes as everyone charges off in the same direction, seemingly all at once. Basically, an information cascade looks an awful lot like what happens when a herd of stockmarket investors all go mad at exactly the same time.

Availability, Again

Quite how the individual psychology works in order to induce these wide social effects isn't understood. Simple behavioural biases like the availability heuristic may be enough under some situations to trigger this type of herding – if the press and the cab drivers are doing nothing but broadcasting the latest set of stock tips then such information is easily available, although of highly dubious (yet approximately equal) quality. Similarly the mere exposure effect suggests that people start to like things more merely by being exposed to it: expose people to enough information about a certain stock and you'll increase the likelihood of wanting to own it, regardless of the fundamentals. Ever had that "must own" feeling after reading about a stock? Kuran and Sunstein looked at a model of availability cascades which links together social interaction and the availability heuristic to create waves of self-replicating and self-reinforcing behaviour. The more information is available to investors the more likely they are to take notice of it, to transmit the information to others and so build up the cascade of information which starts to swamp more rational interpretations of events.It's Good To Talk

This is potentially quite a radical reinterpretation of the way securities valuations move: it's not purely because investors observe price movements and use this as information about whether to trade or not – a classical momentum trading approach. No, this rather amazing idea suggests that people actually talk to each other. This stunning discovery, along with the realisation that humans communicate via bulletin boards, social networking sites and broadcast media, makes it possible to conceive that people may trade in securities on types of information other than that gleaned from securities analysis – you know, like that hot-tip from the shoe shine boy. Sophie Shive has done some interesting research using a model of epidemics based on what she calls "socially motivated trades" – basically trading based on the spread of information through social networks – and has found that these can predict future market returns: "...socially motivated trading can predict stock returns. Individuals themselves over time have become less susceptible to social in°uence but they are more subject to it, and thus the number of trades caused by social in°uence increases slightly over the sample period"Moreover these effects don't disappear: this is real market moving information spreading amongst market participants. Behind this there's some evidence that the asymmetries in market movements we see from time to time, may emanate from a couple of simple human psychological errors.

Conversational Biases

Firstly we have a tendency to present ourselves in the best possible light. These conversational biases usually mean we talk about things which have gone right and tend to avoid discussing those which have gone wrong. This is a perfectly natural bias but has the effect of reducing the amount of bad trading anecdotes which get relayed around social networks. As any brief perusal of stock trading bulletin boards will show we're exposed to way more positive information than we are negative. Secondly we don't discount for the way that information gets relayed around or social networks. Although the empirical evidence on this is limited there is some suggestion, as outlined in DeMarzo, Vayanos, Zweibel, that we're fooled by something they label as persuasion bias: "We assume that agents treat any information they receive as new, independent information, thus failing to adjust for possible repetitions. We refer to this heuristic as persuasion bias because it implies the phenomenon of persuasion. Suppose, for example, that one forms an opinion on a political candidate by reading a newspaper column. Then, by treating the opinions expressed by the journalist each day as new, indep endent information,one would gradually agree more with the journalist's opinions."Essentially we may receive information from multiple people that may actually originate with a single person. In a network single critical nodes – influential and well connected people – may have disproportionately more influence than we realise.Avoid the Stampede

Herding seems to occur in many aspects of the market from mutual fund stock purchases to stock analyst recommendations through to private investor trading and waves of behaviour in corporations who all suddenly decide to do rights issues or make expensive acquisitions or whatever with perfect synchronicity. That this social behaviour is somehow underpinned by individual psychological biases is a certainty, but that's nowhere near enough to help us make money. In fact, sometimes following the herd can be a very profitable activity if you have the personal courage to peel off before everyone else goes over the edge. Not many people can do this and generally ignoring the crowd's signal is the safest route for most investors. How people choose to do this is down to the individual but, as usual, it probably comes down to either focussing on the fundamentals or simply isolating yourself from events. Generally, though, if you have to join a stampede do it early – and leave before the round-up.

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Some interesting thoughts in there. You last paragraph in particular prompts the following thoughts:

1) TA is merely a shorthand by which people ATTEMPT to assess herd behaviour

2) Despite the fact that virtually all TA adherants seem to deny when challenged that TA is predictive, they still attempt to position themselves (and set stops) as if TA was a useful predictor of where the herd will go to next

3) Making money relies on being ahead of the herd in getting in and out. Since TA is backwards-looking, it isn't very useful in helping investors do this.

Oddly enough there is evidence that TA does work, a bit. Certainly there’s no doubt whatsoever that momentum investing is an effective technique, over periods of up to a year. Over periods of over three years looking for mean reversion is the better approach. The problem for momentum investors is deciding when the trend will turn, and I’ve never seen any convincing evidence that TA can reliably do this. In fact if it could then you’d assume that people would try to anticipate the turn to the point where the signal would dissolve in noise.

The question in both cases, which I’m currently pondering, is whether excess returns are really the result of exploiting herding psychological weaknesses or simply the result of taking on additional risk. You probably don’t want to be betting on an up-trend when the market turns turtle, but you probably don’t want to then invest in a bunch of beaten-up cigar butts, aka ‘value’ stocks, either. In fact perhaps the closest thing to a free lunch in markets is buying quality stocks during a downturn and then holding onto them.

Which, if true, means that the problem reduces to deciding what a “quality stock” is …

I'm a UK based technologist (career) and psychologist (academic) with a long-term interest in financial markets, with a particular emphasis (and skill) in how to not make money out of them. When I'm not working or blogging I'm to be found childminding, walking the dog or hiding in the garden shed with a good book :) more »